You’re Pricing It Wrong: Software Pricing Demystified

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Pricing your own product is always a tricky proposition, and the more critical the price is to your product’s success, the more difficult it is to set. It’s easy to look at another product and say how much you would be willing to pay for it, but how can you know how much people would be willing to pay for yours?

There are no absolute truths or perfect formulas for finding the best price, assuming that the “best price” even exists. Instead, take a structured approach to finding a good starting point, and improve it through feedback and testing. But first, you need to understand what the best price actually is.

Riding the Demand Curve

When we price a product, our goal (assuming we’re running a business) is to maximize revenue. We want sales × price = highest possible value.

Economic theory suggests that as we raise the price, the number of sales will drop. Each intersection of price and number of sales can be plotted on a graph, creating what is called a demand curve1.

2

The sweet point is where the intersection forms the largest rectangle. This rectangle represents the calculation of sales × price, and the biggest rectangle represents the biggest revenue.

This makes sense… until you consider that your clients are people, and people do not often make rational purchasing decisions. In his excellent eBook Don’t Just Roll the Dice3, Neil Davidson4 says (emphasis is mine):

Once you’ve determined what your product is, you need to consider its value to your customers. In the case of the Time Tracker 3000, let’s say that it will save a particular customer, Willhelm, three hours of work and that Willhelm prices his time at $50 an hour. That means that Willhelm should buy the Time Tracker 3000 at any price under $150, assuming he has nothing better to spend his money on.

Of course, this assumes that Willhelm is the rational, decision-making machine that economists love. In fact, Willhelm is a flesh-and-blood, irrational human being who doesn’t price his time and calculate costs and benefits. He has a perceived value of the Time Tracker 3000, which may or may not be linked to its objective value.

Neil goes into much more detail than I can in this article, but to recap quickly: perceived value can be different than objective value, and it can affect sales in ways that the demand curve does not predict. For example, when buying a brand-name product, you are intentionally paying a premium because the perceived value is higher, even if the objective value is the same. Some brands purposely price higher in order to increase the perceived value and thus sell more.

Pricing Higher And Selling More

Taking the fictional issue tracker in Neil’s book:

Back to Willhelm and the Time Tracker 3000. If you want to change how much Willhelm will pay for your product, then changing the product is one option, but only if you can also change his perception too. In fact, it turns out that you can change Willhelm’s perception of your product’s worth without touching the product at all. That’s one of the things marketing is for.

That’s right. You can set a higher price without changing your product just by changing the potential customer’s perception of the product. For example, you could increase perceived value by writing better marketing copy (focusing on the value that you’re providing or the pain that you’re solving). A killer demo can do wonders, as can strong testimonials and well-known partners.

One of the best ways to increase perceived value is to have better visual design — which, not surprisingly, is one the weakest links in marketing for most software developers. A well-known fruit company has become a giant by out-designing its competition, and it’s no coincidence: Apple charges a premium because of the perceived value of its products.

One common way to identify perceived value is to check the competition. Are you selling a WordPress plug-in for newsletter management? Google the keywords to see what else is on the market. If you’re in luck, you’ll be providing the only solution in this space. If not, you’ll have to consider that your clients can use Google just as well as you can and thus take your competitors’ pricing into account.

What do you do if a free product does what your product does? In this case, you have four options:

  1. Demonstrate that your product either is clearly superior or has features unique to it;
  2. Work on creating such differentiators;
  3. Win on marketing;
  4. Provide support.

Providing support is an important differentiator; one of people’s biggest deterrents from using a lesser-known free or cheap product is their concern about ongoing problems and future needs. A commercial product that comes with support will often win over customers who want that assurance that someone will be on the other end of the line should they need it.

Providing support has another benefit in addition to increasing the value of the product: it’s a chance to get real feedback! The feedback you get from support requests will enable you to improve the product and thus sell more (or increase the price) in the future.

A Real-World Example

The start-up that I co-founded, Binpress, is a marketplace for source-code components. One of our components, an import and export rules module for Magento5, started out priced very low: $4.99 for a basic license, which is actually the minimum price that we allow.

We noticed that it was getting good traction and that people were looking for this particular functionality and that no good alternatives existed. We suggested to the developer that he raise the price. And he did, in stages:

  • At first, he raised the price to $9.99, which did not affect sales (i.e. the conversion rate stayed the same);
  • He then raised the price to $14.99 — again, the rate of sales remained the same;
  • The price is now $19.99, and sales are slowing down somewhat.

So, the optimized point lies somewhere between $14.99 and $19.99 — more than three times the original price! That is, the developer will generate over three times the revenue simply by optimizing the price and not actually changing the product. Without having tested different points, the developer would still be stuck at $4.99.


The prices should attract your customers, not drive them away. Image Source6

Pricing A New Product

So far, I’ve talked about perceived and objective value and maximizing the demand curve. But what about the initial price tag?

When you go about pricing a product, run through the following exercise.

1. Determine the Product’s Objective Value

How much would people pay if they were indeed rational decision-making machines. With software, the calculation can be as simple as:

(Hourly rate × Development time in hours) − Price = Value

This simple calculation would determine the product’s value if the customer were making a completely logical decision. (Of course, this will vary depending on the hourly rate of the developer and their experience, which will affect development time. But those two numbers are usually related.)

2. Understand the Product’s Perceived Value

Who is your target audience? How will the product help them? (Will it save them time, improve their business, etc.?) Who will ultimately be making the decision to buy your product? (A developer? A project manager? The dude holding the company’s credit card?)

To answer these questions, research your market. What are the competing products? What is the demand? Who needs this solution, and how unique is it? How hard would it be to develop the product from scratch?

The Programmers section of StackExchange has a good overview7 of these considerations. Unless your circumstances are highly unusual, you can find answers to these questions relatively easily by using Google and by visiting relevant community-powered forums and Q&A websites such as StackExchange8.

3. What Value Do I Want to Convey Though the Price?

A product priced at $1.99 sends a very different message to potential customers than one priced at $19.99 — the difference in conveyed value is by an order of magnitude. Don’t lower the price early on merely to try to generate more sales, because you would be conveying to customers that the product is worthless.

After determining the perceived value of the product and deriving a price from that, we can try to optimize the price in several ways…

1. Improve Perceived Value With Marketing

I’ve already covered several factors related to marketing, such as copy, visual design and demos, and I might expand on others in a future post. Consider these elements when trying to increase perceived value. If we find that the perceived value is below our objective value, then we can almost certainly raise it to at least the objective value. And with creative marketing, we could probably go far past that.

2. Improve Objective Value

To quote Joel Spolsky in his excellent article on Simplicity9 (bolding is mine):

With six years of experience running my own software company I can tell you that nothing we have ever done at Fog Creek has increased our revenue more than releasing a new version with more features. Nothing. The flow to our bottom line from new versions with new features is absolutely undeniable. It’s like gravity. When we tried Google ads, when we implemented various affiliate schemes, or when an article about FogBugz appears in the press, we could barely see the effect on the bottom line. When a new version comes out with new features, we see a sudden, undeniable, substantial, and permanent increase in revenue.

Going back to the point I made earlier, you can price higher through differentiation if you understand what people need and then exploit weaknesses in the competition. Everybody uses Magento because it delivers a lot of value, but customers keep complaining about its speed, among other things. Suppose you built a similar e-commerce platform that is blazingly fast? Bingo! You’ve targeted the biggest pain point for your competitor’s clients. Sometimes, having competition is helpful just to know what people really need.

3. Testing

When all is said and done, determining the ideal price from the get go is hard. You’ll need to test several prices and plot the demand curve of your product to find that sweet spot.

4. Tiered Pricing

This is critical from a psychological point of view. By setting just one price for your product, you don’t provide any points of reference (except those of your competition). You can increase the perceived value of your regular price by adding a premium package that is priced much higher. The point of the premium package is not to generate revenue (although it will do that — always give people the option to pay more if they want to), but rather to make the regular price seem like a better deal.

Basecamp pricing options10

Start With A Good Guess And Then Optimize

By now, you should have the basic process down for how to price your product. There are no absolute truths in pricing: it’s best to start from a good guess and then test as much as possible. This article is meant to lay out the process to make that initial guess and the considerations that go into it.

There could be any number of reasons why a product is not selling as well as it should, aside from pricing. Always try to get feedback from potential customers (i.e. your website’s visitors) using tools such as KISSinsights11, Total Feedback12 and even a simple contact form. The reasons could be a lack of information, missing features or simply a broken purchasing link.

What experience do you have in pricing software? I would love to hear about it and any questions you have in the comments!

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Front Cover: Image Source17.

(al)

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I'm an entrepreneur and web developer. Formerly started Lionite, a web development shop and incubator, now I'm CTO on Binpress, a discovery service and marketplace for source-code.

  1. 1

    Pricing up softwares with various options is a complex part of any business strategy and should be dealt with great care. All of the mentioned factors do take part along with many others. Thanks for great article!

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  2. 2

    Nice Article! In case there are multiple pricing plans for the same product (as in your Tiered Pricing example above), then you have multiple rectangle areas under the demand curve (assuming that the demand curve is the same for each pricing plan which, I think it is true for the majority of web-apps). In such a case, the pricing problem falls under the set of problems that need combinatorial optimization to be solved to optimality.

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    • 3

      If you read the article, you’d know that I mentioned the demand curve as a baseline that is not always accurate (See: perceived value versus objective value). You cannot solve this using mathematics, you need to understand how the market reacts to your product, what is the competition, what is your marketing pitch and so forth.

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  3. 4

    Christopher O'Donnell

    September 28, 2011 6:21 am

    The best way to price your software product, especially if it is a new kind of offering without comparables is to elicit accurate feedback from your target market. This is more complicated than simply asking people how much they would pay for something. A friend of mine and I have built a powerful tool to help you price your software products, if you are interested, check it out: priceintelligently.com

    regards,
    Christopher

    -3
  4. 5

    I like the article, but the main catch, for me at least, is: How do you effectively test on the price?
    It’s not like every customer is an isolated island. People talk. And offering two people two different prices makes them feel stupid and the trust in your brand goes down.

    I found it really tough to adjust prices, if you run an SaaS business. Any suggestions?

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    • 6

      Hi Palim,

      You shouldn’t be afraid to experiment with pricing. If you change the price too frequently, you might get backlash but unless you have a very visible product (which usually doesn’t happen before you find the optimal price point), that shouldn’t be an issue.

      Do incremental changes, and make sure to let them get enough traffic to make it statistically relevant. If you are worried about the reaction of past clients, you might consider giving them a rebate or something similar for a limited time (if the price went down).

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  5. 7

    Great article Eran! We’re launching paid version of our web-app in the next few weeks. It will be a tiered plan similar to the example you’ve shown.

    You mention how the premium plan should serve as a point of reference for the regular price point’s value. I’m wondering what your thoughts are on lower price points acting as a stage to “upsell” to premium packages with more features and usage limits. Also what are your thoughts on how free trials should properly function?

    Looking strictly from a “conversion” perspective at our release phase, is it better to have a low cost tier and a free trial to lower our user’s initial commitment and increase conversion? Then once they use the product and truly understand its objective value we can upsell them easier? I understand the power of perceived value and we do take it seriously, but we can’t ignore the significance of “tighter-pockets” all together. Or can we? Please advise. Thanks!!!!

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    • 8

      Absolutely, lower priced packages are a great way to upsell premium packages. A low (or even free) introductory cost could be a great way to introduce your product to prospective clients who might be not feel comfortable spending on your product significant amounts yet. This strategy is more applicable for products that are of the “nice to have” variety instead of the “must have” variety. Developer tools and games usually fall into this category.

      Free trials or limited versions are good ways to allow users to get a taste of the product. If it’s a strong product, it will upsell to the premium versions. I think it’s important to market it as such, so it is not mistaken with a cheap product. The perceived value will be a reflection of how the free / cheap version is presented.

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      • 9

        Awesome! Thanks for the reply and feedback. We’ll take this into consideration. Any thoughts on giving specific users free stuff in exchange for evangelization?

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  6. 10

    Good article, but even a lay treatment should be careful about correctness. This one, in particular, irked me:

    “The price is now $19.99, and sales are slowing down somewhat… So, the optimized point lies somewhere between $14.99 and $19.99 ”

    It depends on the number of sales lost at $19.99 vs $14.99. The extra $5 per unit may well compensate for the lost sales, in which case the best price would be at least $19.99. In general, the price that optimizes profit will not also optimize the number of units sold.

    3
  7. 11

    Excellent article with great examples.

    I’ve written on the pricing topic myself here: http://blog.traindom.com/product-pricing-strategies-and-techniques/

    Perhaps it will add further value to people interested in the subject.

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  8. 12

    Nice article, interesting and well written.

    But I think you don’t quite demonstrate what you wanted to: “Pricing higher and selling more”. By raising the price of this Magento component from $4.99 to $19,99 you only found the optimum rectangle that maximizes turnover (not benefits by the way) and your sales just stayed flat (more or less). In fact, do you really know why sales have changed over the course of time? ie: new competitor on the market? no more support for a previous products from a former competitor? buyers spreading the good news about your product? Finally, are your sales ONLY changing due to price changes? No, they can’t.

    On the other hand, you’ll learn in every marketing school that you can compete on the market regarding 3 axis: a) discount/lowest price (and lowest capabilities), b) best value/market core (where most of your competitors will be) and c) highest price/highest perceived value/highest technical content.

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    • 13

      Hi Emmanuel,

      You make some good points. In this particular case, it is easier to determine, since there are no competing products, and as I’ve mentioned in the article what stayed flat is the conversion rate, not sales. Meaning, the price increases didn’t reduce the perceived value for visitors of the component page. Since nothing else changed on the page, it is easy to make that observation.

      Of course, you can never really tell – perhaps you witnessed a statistical aberration. But according to the data we collected, the price changes had no perceived effect on the conversion rate until it reached a specific point.

      This relates to a comment I left for Chris here – on the difference between “must have” products and “nice to have” products (perhaps I will expand on that in a future article). “Must have” products – as this component is for someone who needs that functionality – can generally price more aggressively until they find their optimal price. “Nice to have” products need to have a lower barrier of entry to convince people to use them, usually using a freemium / trial version model.

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  9. 14

    >>the developer will generate over three times the profit simply by optimizing the price

    Not to be too pedantic, but this is slightly inaccurate, revenue is the better word here, profit can be a very complicated thing to calculate, and many companies purposely skirt the zero profit line (taxes create bizarre incentives…).

    I would also point out that raising prices can often have another profit effect. You can price out your worst customers, removing the cost of supporting them. There’s at least one anecdote I’ve seen (I think it was either softwarebyrob.com or asmartbear.com) that said basically that when they raised their prices for their software somewhere above a threshold (for them, it was something like $25) they stopped getting really time consuming tedious customer service calls. Considering how non technical their core audience was, this was a very big win for them.

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    • 15

      Yes, you are semantically correct. Revenue might be the more appropriate wording. Excellent point about pricing out cheap clients!

      0
  10. 16

    Sorry, I was excited to see this in HN but the first paragraph turned me off. “This rectangle represents the calculation of sales × price, and the biggest rectangle represents the biggest profit.” That’s not true. At all. Your rectangle maximizes sales…which is a very different thing from profit. Maximum profit occurs where marginal revenue meets marginal cost. When people focus on maximizing sales, bad things happen. Even the “software has $0 marginal cost paradigm” only holds true if you provide no additional support, no additional resources, and commit no additional time to that customer or their requests…which is rarely, if ever, true.

    0
    • 17

      You are right about the semantics – revenue should be used instead of profit (it does not maximize sales by the way – rather sales x price).

      0
  11. 18

    Eran, lots of great stuff here. I especially liked the part about the impact of marketing on your product’s perception, and how that affects price. I wrote a similar post about finding the right price for your product using 5 key factors:

    http://blog.hartleybrody.com/2011/09/the-5-essential-factors-to-determine-your-products-price/

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    • 19

      Thanks for the link, Hartley, very nicely written article.

      0
    • 20

      Thanks for that link. Your final note actually was the most important information for me. I think I’ll experiment with the price of my product this weekend, but for new customers only.

      0
  12. 21

    You have raised very good points Eran, although there is no perfect answer to the right pricing strategy. Initially on the basis of Educated guess then there is trial & test method which may allow you to optimize it.

    I would agree as mentioned above that it also depends on the nature of your product. If it is perceived as veblen then its sale may increase (as in case of Apple products) or if the product is a necessity item then it would not highly affect the demand curve (as explained by Alfred Marshall in Price Elasticity of Demand).

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  13. 22

    Using a demand curve is easy. The hard part is creating one that is relevant to your business by doing pricing experiments to measure the price elasticity of demand.

    0
  14. 23

    Is it possible (or appropriate) to use A/B testing on price? In your example, it might be worth setting up 3 price points for the import/export module, and having each customer randomly assigned a price. That way, you could measure conversion rates across each price and determine the sweet spot from the results.

    0
    • 24

      Sounds like a risky move, but certainly possible.

      I know of a few companies that experiment with price in a similar way to this. It all depends on how public the pricing is and if your customers are likely to discuss it – it also depends on what it is that you’re selling.

      Probably worth checking into the legality where you plan on making the sales though, as there are probably some rules about this kind of thing in many places.

      0
  15. 25

    A thing I don’t like with some companies is when they have an offer and after you buy during the offer period the product price goes even lower. You feel like a sucker then and esp. if the company is selling more s/w there are low chances you’ll ever buy any other offer or even anyother s/w at all from them.

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  16. 26

    Continuing on the previous one, it’s better to start with lower price and increase it for testing gradually instead of start with a higher one and decrease it. The idea is that customers who bought early won’t feel like succers (who then won’t rush to buy your new products/versions early but wait for a while for price to go drastically down). An exception to this is holiday periods. You can try a lower price during those but not sure if results you get are safe to consider since people feel more of a rush to take bargains near holiday time

    0
  17. 27

    It’s OK to increase prices up to the product/service perceived value, testing with small intervals, but please do it carefully and always considering 1) your product: is it unique, are we talking about a monoploy/oligopoly? 2) your target’s profile: is demand inelastic to price (i.e. petrol) ? and 3) other external factors (economy, trends, tax changes,etc) And most important tip you didn’t mention: customers are more flexible with price increases up to a certain point where demand lowers, BUT not the opposite! If you lower your prices, it’s bad for your brand image and you will pay it losing customers, as they will feel cheated and will understand cutting costs was performed thanks to a quality reduction resulting in a poor product they won’t see worthy buying. Of course, this price drop effect isn’t applicable to punctual short-term vouchers and promotions.

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  18. 28

    Good article and I’m glad that you addressed the issue with using economics for… well, anything.

    Behavioural economics is still young; but it’s important that we look more into how people actually behave, and not a fictitious set of rules that don’t apply in the real world. The global economic turmoil we’re in now has standard economics (partially) to blame.

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  19. 29

    I like that this article goes into the psychology behind pricing and how people sometimes make their decisions, but you really should stop propagating the fallacy that there is such a thing as “objective value”. This is not just bad economic theory, but it’s false.There is no such thing as “objective value”.

    Value is truly in the eye of the beholder, and in this sense yes, people *are* rational because they act to maximize their perceived value. This is a different way of looking at things and one that more reflects actual human nature, so I’m glad you brought it up here.

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  20. 30

    Thank you for the article. Very informative. While trying to understand how to execute a plan to find the sweet spot for your price, I was wondering if going from a high price to low price works better or the other way around? I have always noticed high to low being being used most of the time. Any thoughts on which one would work better in what situation?

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  21. 31

    Good point, Jason. Enough data needs to be collected to decide whether a price reduction would result in more overall revenue.

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